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Illinois  Manufacturers’  Costs  Association 
76  West  Monroe  Street 
CHICAGO 


I 


The  Preparation  and  Use 

of 

Financial  Statements 


COPYRIGHT  1921 


BY 

Illinois  Manufacturers’  Costs  Association 


Committee  on  Standardization  of  the  Balance  Sheet 

J.  H.  BLISS,  Chairman,  Swift  & Co. 

O.  N.  LINDAHL,  Universal  Portland  Cement  Co. 

H.  G.  HOOK,  Stewart-Warner  Speedometer  Corp. 

C.  V.  FARGO,  Vesta  Battery  Corp. 

T.  W.  HOWARD.  Griffenhagen  and  Associates 


THE  PREPARATION  AND  USE 

of 

FINANCIAL  STATEMENTS 


CONTENTS 

Page 

Foreword 3 

I.  Preparation  of  Financial  Statements 3 

II.  Recommended  Form  for  Financial  Statement. 9 

III.  Accounting  Procedure  to  Develop  Financial  Statements 

Along  Standardized  Lines 10 

IV.  Method  of  Analyzing  Financial  Statements  13 


FOREWORD 


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To  Members  of  Illinois  Manufacturers’  Costs  Association: 

The  years  from  1914  to  the  earlier  part  of  1920  are  often  spoken  of  as  the 
most  unusual  ever  experienced  by  American  Manufacturing  Industries.  This 
was  a period  of  ever-advancing  prices,  of  increasing  volume,  of  intense  indus- 
trial activity  and.  of  unearned  or  unrealized  profits.  Unearned  profits  because 
they  came  with  increasing  volume  and  advancing  values,  and  unearned  further, 
because  they  were  borrowed  from  the  years  to  follow,  when  the  reactionary 
period  of  this  business  cycle  should  come.  That  reactionary  period  has  come. 
And  it  brings  declining  values,  decreasing  volume,  lessened  industrial  activities, 
and  narrowed  margins  of  profit. 

Unusual  as  were  the  times  from  1914  to  1920,  it  is  probable  that  the  times 
ahead  of  us  will  be  even  more  unusual,  and  certainly  far  more  trying,  to  do 
business  in.  The  great  war-time  boom  has  come  and  passed.  The  profits  earned 
in  industry  in  the  future,  far  and  wide,  must  be  earned,  not  with  the  aid  of 
favorable  market  and  operating  and  financial  conditions,  but  in  spite  of  unfavor- 
able markets,  high  costs,  high  wages,  abnormal  overhead,  and  industrial  and 
financial  readjustments. 

The  business  expansion  of  the  years  back  of  us  is  most  clearly  reflected  in 
the  financial  expansion  in  all  kinds  of  business.  With  increasing  prices,  more 
capital  was  necessary  to  carry  inventories,  and  it  took  more  money  to  carry 
accounts  receivable  for  the  same  volume  of  business.  To  meet  increasing  demand 
for  products,  great  sums  of  capital  were  locked  up  in  additions  and  improve- 
ments and  in  new  plants  and  equipment.  The  financial  structure  of  every 
business  organization  reflects  the  expansion  in  business  that  it  has  seen  through- 
out these  years,  through  these  increased  investments  in  inventories  and  accounts 
and  plants  and  equipment.  As  the  expansion  progressed,  the  financial  struc- 
ture was  enlarged  to  meet  the  new  requirements. 

That  business  is  readjusting  itself  is  acknowledged  by  everyone.  That 
volume  and  values  are  seeking  peace-time  levels  is  evident.  That  the  process 
of  readjustment  will  be  a prolonged  and  trying  one,  cannot  be  questioned.  It 
is  just  as  far  from  the  peak  of  war-time  activities  back  to  normal  peace-time 
business,  as  it  was  from  peace-time  business  to  the  peak  of  war-time  activities. 

Readjustment  means  that  business  must  not  only  readjust  its  operations, — 
lower  direct  ^osts, — reduce  overhead  costs, — increase  efficiency, — etc., — but 

3 


means  as  well  a readjustment  of  the  financial  structure  of  the  organization.  As 
this  financial  structure  was  enlarged  to  meet  the  requirements  of  the  period 
of  expansion,  so  must  it  be  contracted  and  readjusted  to  a peace-time  or  normal 
basis  in  the  periods  to  come.  No  concern  could  do  a war-time  business  with 
its  peace-time  financial  structure,  and,  in  the  same  manner,  to  meet  competition 
every  concern  will  have  to  adjust  its  financial  structure  to  peace-time  standards 
as  we  go  through  this  period  of  readjustment. 

It  is  therefore  highly  appropriate  at  this  time  to  consider  the  subject  of 
financial  accounting  and  the  methods  of  making  up  Balance  Sheets  or  Finan- 
cial Statements  which  will  correctly  portray  the  progress  of  readjustments  to 
normal  standards;  and  to  study  the  classification  of  financial  accounts  with  a 
view  of  producing  promptly  the  most  reliable  information  about  the  course 
of  the  business  through  this  financial  readjustment. 

The  purpose  of  this  present  pamphlet  is  two-fold:  First,  to  suggest 
methods  and  forms  for  the  preparation  of  financial  statements  which  will  pic- 
ture correctly  the  financial  condition  of  a concern  and  more  clearly  indicate  the 
facts  about  the  business  which  such  a statement  should  develop.  Secondly, 
through  a discussion  of  the  classification  of  balance  sheet  accounts,  to  promote 
a better  understanding  of  the  principles  underlying  the  handling  of  these  ac- 
counts, so  that  financial  statements  may  be  more  readily  prepared,  and,  when 
drawn  up,  will  portray  correctly  the  financial  position  of  the  concern  and  place 
in  the  hands  of  its  executives  the  information  which  they  will  need  in  guiding 
the  business  throughout  this  readjustment  period. 


4 


I— PREPARATION  OF  FINANCIAL  STATEMENTS 


The  financial  statement  or  balance  sheet  of  a concern  is  a statement  setting 
forth  its  financial  position  at  some  certain  date.  It  is  a picture  of  the  concern, 
stated  in  dollars  and  cents,  indicating  what  it  owns,  what  it  owes,  and  what  it 
is  worth,  net.  It  is  the  portrait  of  the  financial  structure  of  the  organization. 

This  financial  statement  shows  on  the  one  hand  the  sources  from  which 
the  concern  draws  its  capital,  whether  from 

a — Stockholders’  investment,  which  is  represented  by  the  initial  investment 
and  the  surplus  earnings  left  in  the  business, — or 

b — The  investment  of  bondholders  or  capital  drawn  from  other  long-term 
borrowings, — or 

c — Capital  drawn  from  short-term  borrowings,  such  as  current  notes  and 
bills  payable,  open  accounts  payable,  sundry  liabilities,  etc., 

and  it  indicates  on  the  other  hand  how  the  concern  has  invested  this  capital, — 
how  much  of  it  is  tied  up  in, — 

a — Current  Assets  which  are  used  in  the  daily  transactions  of  the  business, 
such  as  cash,  accounts  receivable,  inventories,  etc., — and 

b — Investments  in  Plants,  Machinery,  Equipment,  etc.,  which  represent 
the  property  with  which  the  business  is  carried  on,  as  distinguished 
from  the  current  assets  which  represent  the  capital  turning  over  in 
the  daily  transactions  of  the  business, — and 

c — Investments  in  and  advances  to  other  companies;  securities  owned, 
such  as  bonds,  stocks,  etc.,  investments  in  sinking  funds,  etc., — and 

d — The  amount  of  capital  tied  up  in  intangible  fixed  investments,  such  as 
Goodwill,  Patents,  Trade-marks,  etc. 

It  is  obvious  that  different  concerns  will  draw  their  capital  from  different 
sources  and  will  have  it  invested  in  different  kinds  of  assets,  dependent  upon 
the  character  of  their  business.  Considering  this  fact,  and  also  that  the  pur- 
pose of  the  balance  sheet  is  to  indicate  the  sources  from  which  capital  is  drawn 
and  how  the  capital  is  tied  up  in  the  business,  it  becomes  apparent  that  it  would 
be  impossible  to  lay  out  or  draft  a form  of  financial  statement  which  would 
fully  meet  the  requirements  of  all  kinds  of  industrial  concerns. 

The  balance  sheet  which  would  be  most  appropriate  for  any  given  concern 
is  that  one  which  meets  the  general  principles  upon  which  such  a statement 
should  be  constructed,  and  best  fits  the  individual  business  and  the  financial 
structure  it  purports  to  portray. 


5 


Naturally  balance  sheets  of  different  concerns  will  conform  along  certain 
general  lines,  but  each  individual  balance  sheet  should  develop  the  peculiar 
facts  concerning  the  business  for  which  it  is  drawn  up.  For  instance,  if  it  is 
made  for  a business  of  which  instalment  accounts  are  a feature,  these  instalment 
accounts  should  then  be  set  forth  in  the  balance  sheet  and  distinguished  so 
that  they  may  be  readily  understood  by  the  reader.  Again,  if  consignments 
are  a feature  of  a business,  the  funds  tied  up  in  stocks  out  on  consignment 
should  be  set  forth  in  the  balance  sheet  as  such.  Further,  some  concerns  have 
a liability  on  account  of  packages  which  will  be  returned,  and  if  this  is  a feature 
of  the  business  it  should  be  set  forth  and  so  indicated  on  the  face  of  the  bal- 
ance sheet. 

So  with  the  construction  of  any  balance  sheet,  the  individual  items  to  be 
shown  should  include  every  principal  class  of  assets  and  liabilities  which  are  a 
feature  of  that  business,  so  that  the  picture  which  the  balance  sheet  presents 
of  the  business,  will  be  as  comprehensive  as  is  possible. 

The  broad  general  features  which  should  be  observed  in  the  preparation  of 
any  financial  statement  may  be  briefly  summarized  as  follows : 

a — All  assets  and  liabilities  should  be  stated  gross,  the  object  being  to  show 
the  total  capital  which  the  concern  uses  and  to  show  on  the  other  hand  from 
what  sources  it  draws  this  capital.  Accounts  payable  should  not  be  offset 
against  accounts  receivable,  and  accounts  receivable  should  not  be  offset 
against  accounts  payable.  Net  equity  in  purchases  under  contracts  should 
not  be  shown  among  the  assets  in  the  net  amount,  but  rather  the  total  asset 
should  be  shown  on  the  one  hand  and  the  total  liability  for  which  the  con- 
cern might  be  held,  on  the  other. 

b — The  balance  sheet  should  indicate  clearly  on  both  the  asset  and  liability 
sides,  the  distinction  between  current  accounts  and  fixed  investment.  This 
is  a very  fundamental  distinction, — the  one  represents  the  capital  turning 
over  in  the  daily  transactions  of  the  business ; the  other  represents  the  fixed 
investment,  or  the  house  in  which  the  business  is  carried  on.  It  is  highly 
important  to  set  forth  the  relationship  between  the  fixed  investment  and 
the  current  investment.  This  relationship  will  vary  widely  in  different  in- 
dustries, each  having  a more  or  less  characteristic  proportion  of  capital 
tied  up  in  each  the  current  and  fixed  sections. 

c — The  net  working  capital  should  be  clearly  and  readily  determinable  from  the 
face  of  the  balance  sheet.  It  might  even  be  stated  in  dollars  and  cents  with 
entire  propriety. 

d — The  various  assets  and  liabilities  should  be  logically  arranged  and  grouped 
so  as  to  set  forth  the  total  of  each  class  of  items  correctly.  A balance  sheet 
may  be  mis-stated, — may  actually  be  misleading, — because  of  improper 


6 


arrangement  and  grouping  of  accounts  even  though  every  item  shown  is 
entirely  correct  in  amount  and  designation. 

e — The  basis  for  the  valuation  of  all  asset  accounts  should  be  indicated.  That 
is,  the  face  of  the  balance  sheet  should  show  whether  or  not  a reserve 
is  provided  against  possible  loss  on  accounts  receivable, — whether  or  not 
inventories  are  valued  at  cost  or  market,  and  whether  or  not  adequate  re- 
serves against  possible  shrinkage  in  values,  have  been  provided,  if  such  are 
necessary.  Investments  and  securities  should  show  whether  valued  at 
cost,  market  or  par.  Land,  buildings  and  machinery  should  show  whether 
valued  at  cost  or  at  appraised  values  at  some  definite  date,  and  the  amount 
of  reserves  for  depreciation  should  be  clearly  indicated,  etc.  . 

/ — The  character  and  maturities  of  the  liabilities  should  be  clearly  shown  on  the 
face  of  the  balance  sheet.  Current  liabilities  should  include  all  of  those 
which  would  be  liquidated  within  the  near  future,  such  as  accounts  pay- 
able, notes  payable,  federal  taxes,  dividends  declared,  etc.  Every  issue  of 
long-term  liabilities,  however,  should  be  set  out  and  the  maturity  of  the 
issue,  and  any  peculiar  features  clearly  shown.  Reserves  other  than  ap- 
propriated surplus  should  indicate  clearly  the  nature  of  the  provision  and 
the  possibility  of  its  immediate  requirement. 

g — The  net  worth  of  the  organization  should  be  shown.  This  will  consist  of 
the  stockholders’  initial  investment  in  stock,  together  with  appropriated 
surplus  and  profit  and  loss  or  free  surplus.  The  net  worth  of  any  business 
organization  is  a fundamental  factor.  It  is  immaterial  whether  that  busi- 
ness organization  is  conducted  as  a partnership  or  is  run  by  a private 
individual,  or  is  incorporated.  The  net  worth  in  all  cases  represents  the 
difference  between  all  of  the  assets  which  it  owns  and  has  on  hand,  and 
all  of  its  liabilities.  There  is  no  more  logic  in  showing  the  capital  stock 
and  surplus  items  in  different  sections  of  a corporation  balance  sheet  than 
there  would  be  in  showing  the  initial  investment  of  a prvate  individual  or 
a partner  in  a business  in  a section  of  his  balance  sheet  separated  from  the 
accumulated  earnings  which  he  allows  to  remain  in  the  business. 

The  observance  of  these  general  principles  in  the  preparation  of  a finan- 
cial statement  is  the  practical  limitation  of  the  standardization  of  balance  sheets 
for  industrial  concerns.  To  attempt  to  standardize  beyond  the  observance  of 
these  general  principles  would  mean  limitations  which  would  prevent  a concern 
with  assets  or  liabilities  peculiar  to  itself  from  drawing  up  a statement  which 
would  convey  to  the  reader  all  of  the  features  concerning  its  business  which 
such  a financial  statement  should  convey. 

While  certain  classes  of  businesses,  or  groups  of  industries,  may  readily 
have  standard  forms  for  preparing  their  financial  statements,  even  within  these 


7 


restricted  groups  there  will  be  found  concerns  having  peculiar  accounts,  which 
require  special  treatment,  not  only  in  justice  to  the  concerns  themselves,  but  in 
justice  to  those  who  may  be  interested  in  reading  their  balance  sheets.  The 
maximum  benefit  to  be  derived  from  standardization  is  limited  to  the  meeting 
of  these  few  fundamental  requirements  in  the  preparation  of  financial  state- 
ments. 

Each  concern  should  choose  for  itself  a standardized  form  of  balance  sheet 
which  meets  the  requirements  of  these  general  principles  and  best  fits  its  own 
business,  so  as  to  develop  that  information  which  its  executives  will  find  most 
useful  and  which  pictures  its  financial  structure  most  accurately.  The  financial 
statement  forms  suggested  in  the  following  pages  are  those  which  would  be  most 
applicable  to  average  circumstances.  It  is  of  course  impossible  to  draw  up  a 
form  which  will  recognize  the  unusual  features  that  appear  in  all  of  the  various 
kinds  of  businesses.  These  forms  are  offered  as  suggestions  and  as  an  aid-  in 
explanation  of  the  principles  upon  which  balance  sheets  should  be  constructed. 


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PART  III— ACCOUNTING  PROCEDURE  TO  DEVELOP  FINAN- 
CIAL STATEMENTS  ALONG  STANDARDIZED  LINES 

To  revise  accounting  procedure  and  re-classify  the  accounts  of  a concern 
to  permit  of  developing  a balance  sheet  along  standardized  lines,  as  a matter  of 
accounting  procedure,  is  a very  simple  affair.  There  are  but  two  general  re- 
quirements : 

A — That  each  financial  or  balance  sheet  account  be  clean  and  represent  but  one 
element  or  class  of  assets,  or  liabilities,  and  nothing  else. 

B — That  these  accounts  be  so  grouped  and  like  accounts  be  gathered  together 
in  the  ledger  in  such  manner,  that  sub-totals  representing  the  sum  of  the 
groups  may  readily  be  prepared  from  the  trial  balance  and  transferred 
to  the  standardized  statement  form. 

In  most  organizations  it  will  be  found  that  the  adoption  of  a balance  sheet 
along  more  or  less  standard  lines  will  mean  but  very  few  changes  in  their 
accounting  procedure.  If  each  balance  sheet  account  is  found  to  be  clean  and 
to  contain  but  one  character  of  assets  or  liabilities,  a balance  sheet  may  be  pre- 
pared directly  from  the  accounts  by  making  appropriate  groupings  of  like 
accounts  into  sums  to  be  entered  into  the  balance  sheet. 

It  is  not  necessary  that  various  organizations  have  inflexible  classifications 
of  assets  and  liabilities,  nor  is  it  necessary  that  different  units  or  branches  within 
a given  organization  conform  to  a fixed  classification  of  ledger  accounts.  In  fact 
it  is  immaterial  whether  a concern  carries  a few  financial  accounts  in  its  ledger 
or  carries  many  detailed  accounts, — the  only  requirement  is  that  each  account 
should  represent  but  one  element,  so  that  by  proper  grouping,  appropriate 
totals  of  each  class  of  assets  or  liabilities  may  be  determined  for  insertion  in 
standardized  balance  sheet  forms. 

The  following  exhibit  may  assist  in  making  this  point  clear.  The  first 
column  of  these  asset  and  liability  accounts  indicates  the  prime  accounts  which 
might  be  chosen  by  representative  organizations  as  the  accounts  which  would 
show  in  their  financial  statement.  They  might  have  any  number  of  detailed 
accounts  as  shown  opposite  these  items.  If  they  had  transactions  which  would 
produce  accounts  of  this  character,  naturally  they  should  carry  them  in  their 
books,  but  it  would  only  be  necessary  to  arrange  the  accounts  in  their  ledger 
in  logical  order,  so  that  sub-totals  would  be  readily  available  from  their  period- 
ical trial  balances  to  supply  the  various  items  in  their  financial  statement. 

This  exhibit  may  serve  also  to  indicate  how  various  accounts  are  grouped 
in  the  preparation  of  a condensed  balance  sheet.  It  should  be  borne  in  mind, 


10 


however,  that  when  any  of  the  detailed  accounts  shown  become  sizeable  and  are 
important  factors  in  the  business,  they  should  be  set  out  separately  in  the 
financial  accounts  and  be  shown  separately  in  the  balance  sheet  prepared  for 
the  organization. 

This  exhibit  also  indicates  something  of  the  difficulties  which  would  be 
encountered  in  an  attempt  to  make  a standardized  form  for  all  businesses. 
These  represent  but  a few  of  the  more  unusual  accounts  commonly  found  in 
various  industries.  And  in  every  case  these  accounts  should  set  forth  on  the 
face  of  the  balance  sheet  at  any  time  they  become  sizeable  factors  in  the  busi- 
ness. 


12 


PART  IV— METHOD  OF  ANALYZING  FINANCIAL  STATEMENTS 


The  value  of  financial  statements  in  studying  the  development  of  the 
financial  structure  of  an  organization  is  too  often  overlooked.  Too  few  business 
men  fully  appreciate  the  wealth  of  information  which  may  be  developed  by 
carefully  analyzing  the  balance  sheets  of  a business  at  different  periods.  In 
fact,  the  executives  of  a concern  who  are  provided  with  monthly  balance  sheets 
are  in  a position  to  give  the  most  intelligent  supervision  to  their  business. 

The  changes  of  the  past  five  or  six  years  in  almost  all  concerns  have  been 
so  important  that  careful  analysis  of  their  financial  statements  throughout  this 
period  would  prove  very  interesting;  and  such  analyses  made  of  their  financial 
statements  from  period  to  period  in  the  future  could  not  prove  otherwise  than 
helpful  to  the  executive  in  administering  the  business  throughout  the  periods 
of  readjustment. 

The  single  balance  sheet  of  an  organization  at  one  date  conveys  many  in- 
teresting facts  when  carefully  analyzed,  but  as  usually  prepared  leaves  study 
or  analysis  entirely  to  the  reader  with  the  result  that  often  times  the  full  value 
of  the  statement  is  not  realized.  But  when  these  statements  are  made  up  in 
comparative  form  and  are  carefully  analyzed,  there  may  be  developed  such  a 
wealth  of  information  concerning  the  changes  which  have  come  over  the  or- 
ganization during  the  intervening  periods,  as  would  prove  very  valuable  and 
be  appreciated  by  every  business  executive. 

With  the  thought  of  developing  an  appreciation  of  the  possibilities  of 
such  an  analysis  of  financial  statements,  an  exhibit  has  been  prepared  showing 
the  analysis  of  a representative  balance  sheet,  and  setting  forth  the  salient  facts 
which  such  a statement  should  convey  to  the  reader  (p.  18). 

This  statement  has  been  drawn  up  to  point  out  the  large  number  of  valuable 
and  interesting  statistics  that  may  be  shown  in  connection  with  a balance  sheet. 
Some  of  these  statistics  will  be  found  of  value  in  connection  with  the  analysis 
of  the  yearly  balance  sheets,  and  are  not  particularly  interesting  or  illuminating 
in  connection  with  monthly  balance  sheets.  In  fact,  it  should  not  be  inferred 
from  what  follows  that  it  is  recommended  that  every  balance  sheet  be  analyzed 
as  completely  as  is  here  indicated,  but  that  each  executive  should  select  those 
statistics  which  are  of  real  value  in  connection  with  the  administration  of  his 
business. 

1.  Sources  from  which  Capital  is  Drawn — 

The  percentages  shown  on  the  credit  side  of  the  balance  sheet  indicate  just 
what  proportion  of  the  total  capital  used  by  the  organization  is  supplied  by  its 


13 


stockholders,  represented  by  the  capital  stock  held  by  them  and  the  surplus 
earnings  left  in  the  business;  how  much  capital  is  drawn  from  long-term  bor- 
rowings and  how  much  of  it  from  short-term  borrowings;  that  is,  what  pro- 
portion of  the  total  funds  are  obtained  from  notes  payable,  accounts  payable 
and  such  short-term  liabilities. 

2.  In  What  Manner  Capital  is  Invested — 

The  percentages  on  the  debit  side  of  the  balance  sheet  indicate  the  propor- 
tion of  capital  that  is  kept  in  the  current  turnover  of  the  business,  being  rep- 
resented in  current  assets  such  as  cash,  accounts  receivable,  inventories,  etc.,  and 
how  much  of  it  is  invested  in  the  plant  and  equipment  in  which  the  business 
is  carried  on  and  how  much  is  represented  in  investments  in  other  companies, 
and  intangible  capital,  etc. 

I 

3.  Volume  of  Business  and  Profits — 

Shown  at  the  foot  of  the  statement  are  the  important  facts  which  the  income 
statement  should  develop,  the  sales,  the  operating  profits,  the  profits  available 
for  payment  of  dividends,  and  the  balance  left  in  surplus.  These  statistics  taken 
in  connection  with  the  balance  sheet  aboye  them  make  possible  the  development 
of  many  facts  indicating  the  relation  between  the  financial  structure  of  the 
organization  and  the  business  that  is  carreid  on  with  it. 

4.  Sales  to  Accounts  Receivable — 

This  indicates  in  a broad  way  the  relation  between  the  accounts  outstanding 
and  the  volume  of  business  being  done.  It  is  important  in  figuring  the  relation 
between  sales  and  accounts  receivable  to  get  the  actual  amount  due  from  cus- 
tomers and  its  relation  to  the  charge-sales  for  the  period.  The  amount  of  profit 
is  fixed  when  the  sale  is  made.  It  never  grows  greater  no  matter  how  long 
the  account  is  carried.  On  the  other  hand,  it  incurs  the  costs  of  carrying  the 
investment  and  the  possibility  of  loss  increases  as  time  passes. 

5.  Relation  of  Sales  to  Inventories — 

In  a broad  way  this  indicates  whether  or  not  the  amount  of  capital  tied 
up  in  goods  is  growing  larger  or  smaller  in  relation  to  the  volume  of  business 
done.  This  may  not  represent  the  real  turnover  of  stocks,  but  the  relationship 
between  sales  and  inventories  is  sufficiently  intimate  to  make  this  analysis  sound 
for  all  general  purposes. 

6.  Sales  to  Fixed  Assets — 

The  purpose  in  emphasizing  this  relationship  is  to  develop  information  as 
to  the  amount  of  business  being  done  with  the  given  fixed  investment  and  to 


14 


indicate  whether  or  not  the  expansion  in  fixed  investment  has  been  faster  than 
the  expansion  in  the  volume  of  business  done. 

7.  Sales  to  Total  Assets — 

The  purpose  of  bringing  this  out, — the  relationship  between  sales  and  total 
assets  used, — is  to  emphasize  the  expansion  of  the  business  as  compared  to  the 
expansion  of  the  financial  structure  of  the  organization.  The  point  is  that  the 
greater  the  volume  of  business  which  can  be  done  on  a given  amount  of  capital, 
the  larger  will  be  the  return  upon  the  amount  of  capital  used.  One  of  the  prime 
objects  in  watching  the  finances  of  a company,  is  to  obtain  the  maximum  volume 
of  business  on  a conservative  use  of  capital.  The  volume  of  business  done  in 
dollars  naturally  increased  in  most  businesses  very  greatly  during  the  past 
five  or  six  years,  owing  largely  to  advancing  prices,  and  in  the  periods  that  are 
to  come,  considerable  contraction  may  be  expected  as  prices  decline.  This  rela- 
tionship emphasizes  the  amount  of  capital  used  as  compared  to  the  volume  of 
business  done. 

8.  Percentage  of  Operating  Profits  to  Total  Assets  Used — 

This  is  a fair  measure  of  earnings  on  all  of  the  assets  used.  The  operating 
profits  should  represent  the  total  profits  earned  by  the  organization  before  pay- 
ing interest  or  dividends, — that  is,  before  paying  any  return  for  the  capital 
used.  These  profits  represent  the  return  which  the  organization  has  earned  on 
all  of  the  capital  used,  regardless  of  where  such  capital  came  from, — whether 
it  was  invested  by  stockholders,  bondholders,  note-holders  or  otherwise. 

9.  Percentage  of  Profits  Available  for  Dividends  to  Net  Worth — 

After  paying  for  the  use  of  all  borrowed  capital,  the  percentage  of  profits 
remaining  for  the  stockholders  should  be  figured  to  the  net  worth  or  stock- 
holders’ investment,  which  is  represented  by  capital  stock,  appropriated  surplus 
and  free  surplus.  This  is  the  fair  measure  of  return  on  the  stockholders’  in- 
vestment. The  percentage  of  earnings  on  capital  stock  so  often  figured,  may 
give  an  indication  of  dividend-paying  possibilities,  but  is  not  a fair  measure 
of  the  return  which  the  business  has  earned  on  the  stockholders’  investment, 
because  the  real  investment  of  the  stockholders  is  represented  by  their  original 
investment  in  stock  and  the  earnings  which  they  have  seen  fit  to  leave  with 
the  company. 

10.  Percentage  Earned  on  Common  Stock — 

This  should  be  figured  by  dividing  the  net  earnings  available  for  dividends 
on  common  stock, — after  deducting  preferred  stock  dividend  requirements, — by 
the  amount  of  common  stock  outstanding. 


15 


11.  Book  Value  of  Common  Stock — 

The  book  value  of  common  stock  should  be  figured  by  dividing  the  shares 
of  common  stock  outstanding  into  the  total  equity  of  the  common  stockholders 
in  the  business,  which  is  represented  by  the  common  stock,  appropriated  surplus, 
and  free  surplus,  subject  to  any  claims  which  the  preferred  stockholders  might 
have  against  this  surplus. 

1 

12.  Proportion  of  New  Money  Required, — Borrowed  and  Drawn  from 

Stockholders’  Investments — 

Consideration  of  the  sources  from  which  new  money  requirements  of  a con- 
cern should  be  drawn  is  highly  important.  As  new  capital  is  required  to  take 
care  of  expansion  of  the  business,  part  of  it  may  be  borrowed  and  part  of  it 
must  be  drawn  from  stockholders.  At  all  times  the  organization  should  show 
favorable  margins  of  fixed  assets  over  long-term  borrowings,  and  favorable  mar- 
gins of  total  assets  over  all  borrowings.  The  stockholders  should  be  called  upon 
to  furnish  their  fair  proportion  of  new  money  requirements  either  for  fixed 
investments  or  for  current  working  capital  purposes.  This  may  be  accomplished 
in  a measure  through  leaving  a proportion  of  current  earnings  in  the  business 
from  year  to  year. 

13.  Disposition  of  Profits — 

The  disposition  of  the  profits  of  a concern,  as  between  those  left  in  the 
business  and  those  disbursed  in  the  form  of  dividends,  is  always  a timely  sub- 
ject. In  such  periods  as  the  past  few  years,  a much  larger  proportion  of  the 
profits  of  each  year  should  be  left  in  the  business,  first,  because  they  are  in  a 
measure  unrealized,  and  secondly,  because  they  represent  a part  of  the  new  cap- 
ital requirements  which  should  naturally  be  drawn  from  the  stockholders.  The 
profits  left  in  the  business  within  any  period  should  be  sufficient  to  maintain 
the  working  capital  and  to  protect  it  against  withdrawals  for  construction  pur- 
poses not  covered  by  long-term  borrowings,  or  withdrawals  for  retirement  of 
long-term  debt  through  operation  of  sinking  funds,  etc.,  and  for  any  other  fixed 
investments  not  otherwise  provided  for. 

14.  Net  Working  Capital  and  Ratio — 

The  net  working  capital  is  the  difference  between  the  current  assets  of 
the  business  and  its  current  liabilities.  This  represents  the  net  current  invest- 
ment of  the  organization,  used  in  the  daily  turnover  of  the  business.  The  ratio  * 

represents  the  number  of  dollars  of  current  assets  on  hand  compared  to  the 
dollars  of  current  liabilities  owing.  The  ratio  which  obtains  in  different  indus- 
tries ranges  from  $1.75  to  $2.00  common  to  some,  to  $4.00  to  $5.00  common  in 
other  industries. 


16 


The  importance  of  following  the  net  working  capital  in  a business  from 
period  to  period  throughout  the  future,  cannot  be  over-emphasized  because  the 
contraction  which  the  period  of  readjustment  will  bring  must  occur  very  largely 
in  the  current  assets,  especially  inventories  and  accounts  receivable,  and  any 
shrinkages  absorbed  in  these  accounts  directly  reduce  the  margin  of  net  working 
capital  and  the  ratio. 

These  easy  or  unrealized  profits  of  the  past  few  years  have  tended  to  greatly 
expand  the  net  working  capital  of  most  companies,  for  that  is  the  first  effect  of 
profits, — to  increase  the  working  capital.  In  the  same  manner  readjustments  ♦ 

in  the  values  in  the  years  ahead  and  narrowing  margins  of  profits  will  tend  to 
reduce  the  net  working  capital.  Liabilities  created  in  the  borrowing  of  cheap 
money  will  have  to  be  repaid  in  the  future  with  dearer  money. 

Such  factors  as  dividends  paid  in  cash,  additions  and  improvements  to 
plants  and  equipment,  long-term  debt  retired,  etc.,  all  tend  to  decrease  the  net 
working  capital  in  the  business,  and  the  importance  of  protecting  this  net  work- 
ing capital  of  a business  cannot  be  over-emphasized  in  such  periods  as  the 
present. 

Following  is  an  exhibit  showing  the  method  of  analyzing  a representative 
Balance  Sheet  so  as  to  bring  out  these  important  factors,  and  to  show  the  trend 
of  the  financial  affairs  of  a company.  Analyses  of  this  character  may  be  made 
of  any  concern’s  balance  sheets.  For  the  purpose  of  getting  a “far-away 
look”  at  the  financial  affairs  of  a concern — and  this  is  important — the  balance 
sheet  of  earlier  years  may  be  compared  to  the  present.  Most  interesting  facts 
may  be  developed  by  comparing  balance  sheets  of  1914  and  1920  for  most  any 
organization. 


17 


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It  should  be  noted  that  all  of  the  important  points  about  the  affairs  of  a 
concern  are  developed  in  the  analytical  balance  sheet  presented.  This  method 
of  analysis  may  readily  be  applied  to  any  concern’s  financial  statement. 

In  addition  to  the  points  already  developed,  this  comparative  balance  sheet 
gives  ready  answer  to  the  usual  question  of  what  were  the  changes  in  financial 
position  during  the  period.  For  convenience  these  may  be  summarized  very 
1 briefly  from  the  foregoing  exhibit  as  follows : 

New  Funds  Coming  Into  the  Business  During  the  Year: 


I — By  increasing  the  Common  Stock  Outstanding $1,500,000.00 

II — By  increasing  the  amounts  of  Bonds  Outstanding 500,000.00 

III —  By  Surplus  Net  Profits  left  in  the  Business 712,000.00 

IV—  By  Profits  withheld  in  the  Business  by  Reserves 50,000.00 

Total  $2,762,000.00 


Which  Were  Used  for  the  Following  Purposes: 

I — Additional  Investments  in  Plant  and  Equipment $ 582,000.00 

II — Additional  Investments  in  Other  Companies,  etc 500,000.00 

III— Balance  remaining  as  Increase  in  the  Net  Working  Capital  1,680,000.00 

Total  as  above  $2,762,000.00 

'1 


A simple  statement  of  this  character  may  be  readily  prepared  from  com- 
parative balance  sheets  of  any  concern,  and  tells  in  an  understandable  way  the 
information  which  any  business  man  wants  to  know  about  his  business.  It  is 
a simple  and  readily  understood  answer  to  the  questions,  what  new  money  did 
we  bring  in  and  how  was  it  disposed  of. 


* 


19 


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UNIVERSITY  OF  ILLINOIS-URBAN  A 
657 IL6P  C001 

Preparation  and  uae  ol  financial  stateme 


